FIN 924

Topic 1: Introduction to valuation and

financial statements

Penman: Chapter 1 & Chapter 2

1
Where we are?
Topic 6: CH 9 & 10 Topic 7: CH 11 & 12
Topic 1: CH 1 & 2 Analysis of shareholders' Analysis of the cash flow
Introduction to valuation equity, the balance sheet and statement
and financial statements the income statement Analysis of profitability

Topic 2: CH 3 & 4
-Use of financial statements Topic 5: CH 7 & 8
in valuation Topic 8: CH 13 & 14
Valuation and active investing Analysis of growth and
-Cash vs accrual accounting Viewing the business through
and discounted cash flow sustainable earnings
financial statements. The value of operations and
valuation
enterprise ratios

Topic 3: CH 5
Accrual accounting and
Topic 4: CH 6
valuation: pricing book values Subject revision
Accrual
7905AFE Corporate accounting and
Finance
valuation: pricing earnings
Chapter 1: Introduction to Valuation

1. Firm stakeholders and the information they need.

2. Fundamental Investing vs Other Techniques.

3. The Professional Analyst

4. The connection between Business Analysis and

Financial Statement Analysis
Users of Firms’ Financial Information

• Equity Investors • Litigants

-Investment analysis -Disputes over value in the firm
-Management performance evaluation • Customers
• Debt Investors -Security of supply
-Probability of default • Governments
-Determination of lending rates -Policy making
-Covenant violations -Regulation
-Taxation
• Management -Government contracting
-Strategic planning • Competitors
-Investment in operations
-Evaluation of subordinates
• Employees
- Security and remuneration
Investment styles
1. Intuitive Investing
- Rely on intuition and hunches: no analysis
2. Passive Investing
- Accept market price as intrinsic value: no analysis
- This is the “efficient market” approach
3. Fundamental Investing: Challenge market prices
- Active investing
- Defensive investing

*A Motto for the Course*

Price is what you pay, value is what you get
The Cost of Each Approach
1. Danger in intuitive approach:
-Self deception; ignores ability to check intuition
2. Danger in passive approach:
-Price is what you pay, value is what you get:
-The risk in investing is the risk of paying too much
3. Fundamental analysis:
-Requires work !
Defensive investment requires analysis: a defense against
paying the wrong price (or selling at the wrong price)
-The Defensive Investor
Active Investment requires analysis: an opportunity to find
mispriced investments
-The Active Investor
Sample questions faced by fundamental investors

Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14.
– Is Dell’s P/E ratio too high?
– Would one expect its price to drop?

Dell traded at 9.3 times earnings in 2012

– Is this too low?

Ford Motor Co. traded at a P/E of 5.0 in 2000.

– Is this too low?

Ford Motor Co. traded at 2.5 earnings in 2012.

– Is this too low?

Google Inc. had a market capitalisation of $201 billion in 2012.

– What future sales and profits would support this valuation?

Coca-Cola had a price-to-book ratio of 4.9 in 2012.

– Why is its market value so much more than its book value?

Google went public in 2004 and received a very high valuation in its IPO.
– How would analysts translate its business plans and strategies into a valuation?
– Was the IPO price appropriate, or was the market over-excited?
Active investing needs a beta and an alpha technology
Beta Technologies:
– Calculates risk measures: Betas
– Calculates the normal return for risk
– Ignores any arbitrage opportunities
Example: Capital Asset Pricing Model (CAPM)

Alpha Technologies:
– A measure of performance on a risk-adjusted basis
– Tries to gain abnormal returns by exploiting arbitrage
opportunities from mispricing
– Alpha = r – (Rf + beta * (Rm – Rf ))
Investing in a Business The capital market:
Trading value

The firm: The investors:

The value generator The claimants on value

ld y
rs

ho ar
s
e
Cash from loans

er
bt nd
ld
Cash from sale

De eco
th
of debt

eb

S
Financing
Interest and loan

D
Activities

Activities
Investing

repayments
Operating
Activities

s
er

ol ry
Cash from share issues

ld

rs
eh da
ho

de
Cash from sale

ar on
re
of shares

Sh Sec
a
Sh
Dividends and cash from
share repurchases

Business investment and the firm: Value is surrendered by investors to the firm. The firm adds or loses
value, and value is returned to investors. Financial statements inform about the investments. Investors
trade in capital markets on the basis of information on financial statements.
The Firms Activities
Financing Activities:
• Raising cash from investors and returning cash to
investors

Investing Activities:
• Investing cash raised from investors in operational
assets

Operating Activities:
• Utilising investments to produce and sell products
 The Firm and Claims on the Firm

Firms Households and Individuals

Business Business Business Debt Household

Assets Debt (Bonds) Liabilities

Business Business Equity Net

Equity (Shares) Worth

Other
Assets

Value of the firm = Value of Assets

= Value of Debt +Value of Equity

V0F  V0D  V0E

Typically, valuation of debt is a relatively easy task.

The Business of Analysis: The Professional Analyst

• The outside analyst understands the firm’s value in

order to advise outside investors
– Equity analyst
– Credit analyst

• The inside analyst evaluates plans to invest within the

firm to generate value

• The outside analyst values the firm.

• The inside analyst values strategies for the firm
The Analysis of Business

Understanding the business is a necessary prerequisite

to carrying out a valuation
(1) Understand the business model (strategy)
(2) Master the details

The financial statements are a lens on the business.

Financial statement analysis focuses the lens.

Knowing the business

Products/Services
– Type of products
– Consumer demand
– Brand name & patent protection, etc.

Technology
– Production process
– marketing & distribution
– Cost structure & economy of scales, etc.
Knowing the business (cont.)

Knowledge Base
– Industry trend of technology change
– R&D investment

Competition
- Concentration in the industry
– Barriers to entry
– Firm’s position in the industry, etc.
Knowing the business (cont.)
The Management
– Management’s track record
– Focus on shareholders or their own interests
– Strength of corporate governance

Political, Legal and Regulatory Environment

– The firm’s political influence
– Legal and regulatory constraints
– Business taxation, etc.
Knowing the business (cont.)
Valuation techniques
Methods that do not involve forecasting (Ch 3)
– The Comparables approach, multiple screening, Asset-based
valuation

Methods that involve forecasting

(Chapter 4)
– Dividend discounting
– Discounted cash flow analysis (DCF)
(Chapter 5)
– Pricing book values: residual earnings analysis
(Chapter 6)
– Pricing earnings: earnings growth analysis
Tenets (principles) of sound fundamental analysis

When buying a business, know the business.

Value depends on the business model, the strategy.

Good firms can be bad buys.

Anchor a valuation on what you know rather than speculation.

Beware of paying too much for growth.

When calculating value to challenge price, beware of using price in the

calculation.

Stick to your beliefs and be patient; prices gravitate to fundamentals, but

that can take some time.
Anchoring Valuation in the Financial Statements

Anchor a valuation on what you know rather than

speculation

Financial statements provide an anchor

Value = Anchor + Extra Value

For example:
Value = Book value + Extra value
Value = Earnings + Extra value

The valuation task: how to find (calculate) the extra value

 A Framework for Valuation Based on
Financial Statement Data

FORECASTS OF EARNINGS BUDGETS,

(and Book Values) TARGETS,
FORECASTS OF
FORECASTED EVA
CASH FLOWS
* Performance Evaluation
*Benchmarking

DISCOUNTED
RESIDUAL EARNINGS
DISCOUNTED
CASH FLOWS FORECASTING

VALUE OF CURRENT AND PAST

THE FIRM/ FINANCIAL STATEMENTS
DIVISION (analysis of information,
trends, comparisons, etc.)
Chapter 2: Introduction to financial statements
1. Financial Statements paint a picture of the firm

2. Components of each Financial Statement

3. How the financial statements fit together (‘articulate’)

4. Accounting Relations and Financial Statements

5. The Stocks and Flow Equation

6. Financial Statement Anchoring

- Important ratios
The Four Financial Statements
1. Balance sheet
2. Income statement
3. Cash flow statement
4. Statement of shareholders’ equity

The financial statements are the lens on the business.

They draw a picture in two ways:
– The way that the component parts of the statements fit
together sketches out the picture
– The numbers reported within each component fills out the
sketch
The Balance Sheet:
Nike, Inc., 2010

2-24
How Balance Sheet Components Fit Together

Assets = Liabilities + Shareholders’ Equity

14,419.3 = 4,665.6 + 9,753.7

Or

Shareholders’ Equity = Assets – Liabilities

9,753.7 = 14,419.3 – 4,665.6

Compared to:

Value of Equity = Value of Firm – Value of Debt

The Income Statement:
Nike, Inc., 2010

2-26
The components of the Income Statement
The income statement often groups like expenses in categories to report
a number of components of net income. Typical groupings in income
statements yield the following sequential components:

Operating income is
Net Revenue – Cost of Goods Sold = Gross Margin sometimes called EBIT.

Gross Margin – Operating Expenses = Operating Income

Operating Income – Interest Expense + Interest Income = Income before Taxes

Income before Taxes – Income Taxes = Income after Taxes

Income before Extraordinary Items + Extraordinary Items = Net Income

Net Income – Preferred Dividends = Net Income Available to Common

Operating income is sometimes called EBIT.

The Cash Flow
Statement :
Nike, Inc., 2010
The Components of the Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing
+ Cash from Financing
• Example:
• 788 = 3,079.1 - 2,291.1 = 3,164.2 + (-1,267.5)
+ (-1,061.2) – 47.5
loss from exchange rate
The Statement of
Shareholders’
Equity:
Nike, Inc., 2010
The Components of the Equity Statement

The Stocks and Flow Equation:

Ending equity = Beginning equity + Comprehensive income – Net payout to shareholders

9753.7 = 8693
+ 1754
- 693.4

Comprehensive income = Net income + Other comprehensive income

1754 = 1906.7
+ (-159.2 + 87.1 + 44.8 - 121.6 - 3.8)

Net payout to shareholders = Dividends + Share repurchases – Share issues

693.4 = 514
+ 754.3 - (379
+40 +159 -2.9)
 The Articulation of the Financial Statements:
How They Fit Together
Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations
Balance Sheet (t-1) Balance Sheet (t)
Cash from investing
Cash Cash from financing Cash
+ Other Assets Net change in cash + Other Assets
Total Assets Total Assets
- Liabilities - Liabilities
Statement of Shareholders’ Equity
Owners’ equity Owners’ equity
Investment and disinvestment by owners
Net income and other comprehensive income
Net change in owners’ equity

Income Statement

Revenues
-Expenses
Net income
 How Parts of the Financial Statements Fit Together
The Balance Sheet

Assets
 Liabilities
= Shareholders' Equity

The Income Statement

Net Revenue
 Cost of Goods Sold
= Gross Margin
 Operating Expenses
= Operating Income before Taxes (EBIT)
 Net Interest Expense
= Income Before Taxes
 Income Taxes
= Income After Tax and before Extraordinary Items
+ Extraordinary Items
= Net Income
 Preferred Dividends
= Net Income Available to Common

Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash Flow from Operations

+ Cash Flow from Investing
+ Cash Flow from Financing
= Change in Cash

Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income
Statement)
Dividends
Net Income + Share Repurchases
Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income  = Comprehensive Income  Share Issues
 Net Payout to Shareholders  = Net Payout
= Ending Equity
 The PB Ratio: Intrinsic Value and Book Value
Intrinsic Premium:
Intrinsic Value of Equity – Book Value of Equity

Market Premium:
Market Value of Equity – Book Value of Equity

Intrinsic Price-to-Book Ratio: Intrinsic Value of Equity

Book Value of Equity

Price-to-Book Ratio: Market Value of Equity

Book Value of Equity
Percentiles of P/B Ratios for U.S. Firms, 1963-2010
The PE Ratio: Principles of Earnings Measurement

Recognise value added only when you have a customer

– Revenue recognition principles
Add value when it has been earned (usually when a sale
is made).
– Matching principle
Match expenses against revenue for which they are
incurred.

Accounting value added (earnings) = Revenue – Expenses

Price-to-Earnings ratio (P/E ratio)

– P/E = Current stock price / earning per share (EPS)
Percentiles of P/E Ratios for U.S. Firms, 1963-2010
 Related workshop questions

– Chapter 1: CQ 1, 2, 4, 7; Ex 1, 2, 6
– Chapter 2: CQ 2, 3, 5, 6; Ex 1, 2, 3, 4, 9, 10
 Next Topic…

• Topic 2: Use of financial statements in valuation

AND Cash vs accrual accounting and discounted
cash flow valuation. Penman Chapters 3 & 4
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